What is a Sole Proprietorship?
A sole proprietorship is a business that is directly owned by a single individual. It is not incorporated, so that the sole owner is entitled to the entire net worth of the business, and is personally liable for its debts. The individual and the business are considered to be the same entity for tax purposes.
Advantages of a Sole Proprietorship
The advantages of a sole proprietorship are noted below.
Simple to Organize
The initial organization of the business is quite simple. At most, the owner might reserve a business name with the secretary of state. It is also quite easy to upgrade to other forms of organization.
Simple Accounting
A sole proprietorship could use a simple checkbook-based system for its accounting, depending on the size and complexity of its operations.
Simple Tax Filings
The owner does not have to file a separate income tax return for the business. Instead, the results of the business are listed on a separate schedule of the individual income tax return (Form 1040).
No Double Taxation
There is no double taxation, as can be the case in a corporation, where earnings are taxed at the corporate level and then distributed to owners via dividends, where they are taxed again. Instead, earnings flow straight to the owner.
Complete Control
There is only one owner, who has absolute control over the direction of the business and how its resources are allocated.
Disadvantages of a Sole Proprietorship
The disadvantages of a sole proprietorship are noted below. In short, the unlimited liability aspect of the sole proprietorship and the inability to bring in additional investors tends to limit its use to smaller organizations that require reduced levels of funding.
Unlimited Liability
The chief disadvantage is that the owner is entirely liable for any losses incurred by the business, with no limitation. For example, the owner may invest $1,000 in a real estate venture, which then incurs net obligations of $100,000. The owner is personally liable for the entire $100,000. An adequate amount of liability insurance and risk management practices can mitigate this concern.
Self-Employment Taxes
The owner is liable for a 15.3% self-employment tax (social security and Medicare) on all earnings generated by the business that are not exempt from these taxes. There is a cap on the social security portion of this tax. There is no cap on the Medicare rate – instead, the rate increases by 0.9% at certain threshold levels.
No Outside Equity
The only provider of equity to the business is the sole owner. Funding usually comes from personal savings and debt for which the owner is liable. For a large increase in capital, the owner would likely need to use a different organizational structure that would admit multiple owners.
What is Sole Proprietorship?
A Sole proprietorship is a business, owned, controlled and managed by a single individual. A Sole Proprietor reaps the financial rewards and is responsible for all risks and liabilities while conducting the business. It is suitable for individually managed occupations like salons or small retail shops.
Features of Sole Proprietorship
The main features of a Sole Proprietorship are as follows:
- Legal Formalities – No legal formalities are required to either commence or to shut down a sole proprietorship. But the owner must have a special license or certificate to run the business for specific occupations. For example, a sole proprietor planning to start a pharmacy must have a pharmacist’s degree.
- Unlimited Liability – The sole proprietor is liable for the success or failure of their financial transactions. In case the proprietor takes a loan and fails to repay it, the creditors can attach the business owner’s property to recover the loans.
- Risk and reward – A sole proprietor has complete ownership over the profits or losses from their firm’s operations.
- Control – The rights and responsibilities of a sole proprietorship lies solely with its owner. No other person can interfere in the business activities of a sole proprietor without prior permission.
- Separate Entities – The owner and their business are separate entities in most forms of business organisations except sole proprietors. The entity has no identity without the proprietor since that person carries out the day-to-day activities of the business.
- Continuity of business – The existence of a business is related to its owner. Events like death, insolvency, imprisonment, terminal illness, etc., of the sole proprietor can adversely affect the business or force it to shut down permanently. If there is a legal heir or beneficiary to the sole proprietor, that person can run the entity if the proprietor cannot continue.
There are several benefits as well as limitations of running a sole proprietorship. We will discuss some of those points below:
Advantages –
- Swift decisions – A sole proprietor has complete responsibility in terms of making business decisions. It results in faster decision-making for the business as there is no need to consult multiple parties for every minor issue.
- Confidentiality – A sole proprietor can keep all business-related information to themselves as the business’s only decision-maker. The law does not bind them to make the accounts of a sole proprietorship public.
- Profit-sharing – A sole proprietor has complete ownership of profits arising from business operations. They are not obligated to share profits with anyone else.
- Fulfilment – Since a sole proprietor is responsible for both risks and rewards of their business, even a minor success can give a greater feeling of pride and satisfaction than other business forms.
Disadvantages –
- Lack of Resources – It is challenging to raise vast amounts of capital in a sole proprietorship compared to a partnership or company. This form of business runs mainly on personal savings and borrowings made by its owner. Lack of adequate finances can become an obstacle in growing the business.
- Dependence on owner – The owner and their business are a singular entity in a sole proprietorship. While this has several advantages, the continuity of this form of business depends solely on the owner’s well being. In case of death, insolvency, imprisonment, etc., it can shut down if there is no successor or heir to continue the business.
- Unlimited Liability – If the proprietor cannot pay debts arising out of business from its assets, his/her personal property is also at stake. This results in sole traders taking zero or very minimal risks to ensure the survival of the business.
- Management – The proprietor has to perform most or all the activities related to the business like purchase, client relationships, sales, marketing, accounting, etc. They may employ others to help in business operations, but limited finances may prevent the owner from getting full-time staff and give them attractive remuneration. As such, the proprietor may have to carry out all activities without much assistance from others.
Conclusion
Sole proprietorship is a fascinating form of business, but it comes with its own set of limitations. It is suited to certain occupations and it allows complete control over decision making and profit-sharing. Still, there is also a risk of considerable liabilities in case of failure of a business.
Also See
- Difference between Sole Proprietorship and Partnership
- MCQs on Sole Proprietorship